If you want to get a return on your savings but also want a low-risk investment option, certificates of deposit (CDs) and bonds are two good choices. Both allow you to get some interest payments on your cash beyond what you earn from standard savings and checking accounts. The main differences between the two are who issues them and how you earn a profit from them.
What's the Difference Between Bonds and CDs?
|Issuer||Corporations and governments||Financial institutions|
|Interest Rates||Fixed, floating, and zero||Set when issued|
|Liquidity||More liquid||Less liquid|
|Risk||More risk||Less risk|
|Yields||Depends on the bond's interest rate||Set by the interest rate|
Certificates of deposit are similar to saving accounts. They are also similar to loans because the bank uses the money and promises to repay you for the loan with the principal plus interest. You place your money in a CD, and the bank guarantees you a certain interest rate for the length of your loan.
A bond is another kind of loan, but you're lending to a corporation or a government in this case. Your loan is used in the same manner, and there are a few more options for paying you back for your loan.
Bonds are a little bit more complicated than CDs. You'll receive fixed or floating interest payments (called the coupon), or you can buy a zero-coupon bond.
Fixed-rate bonds give you the same interest payment no matter what the market does. Floating rate bonds have rates that vary with the market, and a zero-coupon bond has no interest payment—but you'll give the entity a set amount of money and receive the face value of the bond at maturity.
Bonds can give you good interest income but can lose value if rates go up.
If you own a 20-year bond with a rate of 3%, for example, it may be less attractive to a potential buyer if interest rates rise to 3.5%. This may not be too big a deal if you are in short-term bonds because interest rates usually don’t change dramatically in the short term. But long-term bonds may be less attractive under this scenario.
The interest you'll make on a bond is affected by market interest rates, just like CDs. However, bond prices move inversely to the market, so as interest rates rise, new fixed-rate issue bonds will be less expensive and pay higher yields.
Certificates of deposit are not much different than savings accounts. With CDs, you are simply putting money in the bank and agreeing to not withdraw it for a set period in exchange for a higher interest rate. The longer you are willing to have your money tied up, the higher the interest rate you will get. CDs are insured by the Federal Deposit Insurance Corporation (FDIC), just like other bank deposits, and thus there is a virtual guarantee you won’t lose money. In an environment of rising interest rates, CDs offer higher rates as well.
When interest rates rise, it’s generally a good thing for those considering putting money into CDs. Higher interest rates mean more income, after all. However, it may be disadvantageous to put money in a long-term CD if interest rates are rising quickly because you might be locked into one rate and miss out on the chance to make more money if rates go up.
Many investors set up “CD ladders” to place money in various CDs with different maturity dates. This way, they never have all of their money tied up all at once.
In terms of liquidity, once you lock your money up in a CD, you can't take it out without paying a penalty. Banks have recently started offering CDs with penalty-free early withdrawals, but they're subject to specific rules, and you'll receive a lower interest rate on this type of CD.
On the other hand, bonds are much easier to convert back to cash without paying any penalty.
Generally speaking, bonds and CDs are considered “safe” investments because they offer a steady income without the volatility of stocks. For older people who want to preserve their savings during retirement, these are good vehicles.
CDs are generally safer than bonds because they are not much different than simple savings accounts, and there’s an FDIC guarantee for anything under $250,000. The only real risk of losing money on a CD is if inflation quickly outpaces interest income, but that risk is very small because CD interest rates are designed to track the consumer price index.
U.S. Treasury Bonds, for example, are considered extraordinarily safe investments because the United States never defaults on its debt. There are even Treasuries known as Treasury Inflation-Protected Securities (TIPS), which are indexed to inflation.
Many people find bonds to be slightly more lucrative overall, but they can come with more risk.
Corporate bonds from very large and stable companies are usually fairly safe, as well. But if you are seeking higher rates from bonds, you may choose to purchase bonds labeled “non-investment grade,” which means they carry some risk that the borrower will not be able to pay back lenders.
Bonds can be almost equally safe, but it depends on the type of bond and the borrower's creditworthiness.
Since CDs are issued with set interest rates by banks, there is nearly a guarantee that you'll receive the interest payments—especially if the issuer is a large financial institution. In addition, the longer the term of the CD, the higher the rate the bank will pay, so it will yield more.
If a bond has a fixed rate, then it will pay that rate for its lifetime. However, a floating-rate bond yield will change with the interest rate over time, so it can offer high yields in times when rates are rising and lower yields when rates are dropping.
As interest rates rise, bond prices go down. That’s why fewer investors have purchased long-term bonds as interest rates have been climbing steadily upward.
Zero-coupon bonds always yield their face value at maturity (as long as the issuer still exists).
Short-term bond yields are often slightly lower than the rates offered on CDs, sometimes making CDs a better investment.
Which Is Right For You?
Your decision should be guided by how you'll be paid and the amount of risk you're willing to take on. If you can handle a little more risk along with the higher returns of bonds and need more liquid assets, bonds could be a good choice. However, if you have the money you can put aside to gain interest for a long time with low risk, CDs might be better for you.
It's possible to design future income with both CDs and bonds using ladder strategies, so it all comes down to your risk tolerance and how you want your money to work for you.
Other CD Information
Before putting money in CDs, it is worth asking whether there are other investment options out there. Interest rates are still at historically low levels, and you might be able to get higher returns from stocks.
If you're concerned about the stock market's volatility, you might consider dividend-paying stocks that offer a relatively stable share value. Most of these types of stocks have income levels that are considerably higher than CDs or bonds.
There is always risk when owning stocks, but younger investors who are far away from retirement may find them more useful investments than bonds or CDs.
The Bottom Line
CDs and bonds are issued by different entities and have many differences. Using the different rates, liquidity levels, yields, and their responses to the market, investors use them in a variety of ways to generate income.
However, they are rarely used individually as investments but rather to hedge the risk of other investments. Many investors roll their stocks and other volatile investments into CDs and bonds to preserve capital and generate additional income after a lifetime of investing.